Time Warner (TWX) is one of the world’s leading entertainment companies. The company owns AOL, 84% of Time Warner Cable (TWC) , Warner Brothers, HBO and a leading stable of cable networks including TNT, TBS and CNN. Time Warner also still owns its iconic magazine titles including Time, People and Sports Illustrated.
In early 2009, Time Warner will split off TWC, leaving TWX as a pure-play content company. Presently, TWC produces approximately half of EBITDA. After the split, the new TWX will get more than half its EBITDA from Cable Networks, with AOL and Filmed Entertainment (movie and TV production) generating another 20% each. The balance will be from magazine publishing. New TWX will have about $29 billion in sales and $6.4 billion in EBITDA. Debt will be $9 billion to $10 billion, less than 2 times EBITDA, leaving TWX with the best balance sheet in major media. Free cash flow will likely be $2 billion to $3 billion.
Adjusted for the TWC split, TWX is trading at less than 5 times 2009 EBITDA and about 7 times EPS. I am assuming that EBITDA will fall by 12% in 2009. This is below consensus, which is falling.
Short-Term Catalysts
Valuation-based ideas have not worked as the market crashed, but TWX is really cheap. In this case, cheap will matter because the split from TWC provides a catalyst to recognizing the value. TWC shares have outperformed TWX shares, making TWX shares cheaper post-split. Once the split is finalized, investors will look at New Time Warner and see a mix of assets that have low capital intensity and produce high free cash flow. The company will have a remarkably good balance sheet, making a material dividend or share buyback or an accretive acquisition a positive outcome.
Time Warner is also attractive at the operating level. AOL and Publishing are going to struggle in 2009, with double-digit declines in advertising. The film and TV businesses should be flattish in 2009; cable networks remain the best-performing media assets, and Time Warner’s nets have been leading the industry for more than a year. About 70% of Time Warner’s operating income should be down no worse than 5% in 2009, a good performance relative to media and many other consumer discretionary sectors.
Long-Term Drivers
Time Warner will have one of the most attractive asset mixes among diversified media companies after the TWC split. Both the growth and free cash flow profile will be attractive. Eventually, AOL will be resolved, either by turning it around or (more likely) by selling it. Any outcome for AOL wherein Time Warner reduces its exposure is bullish.
Time Warner will also benefit long term from the relatively poor management over the past decade. Time Warner’s margins are below peers such as Disney (DIS) and News Corp. (NWS.A) , as is the consistency of its financial results at its film studios and cable networks. It seems backward, but the historically poor performance gives Time Warner more room to pull its financial results up to its peers, thus driving superior growth.
After the split, look for a big share buyback, material dividend, accretive acquisition or possibly a combination of all three. Depressed valuations across media dramatically reduce the risk that Time Warner uses its stellar balance sheet to make a dilutive acquisition.
What Could Go Wrong
The overwhelming risk for TWX shares is that advertising deteriorates further, driving 2009 financial results significantly below even the lowest estimates. Given negative sentiment toward AOL and Publishing, any accelerated decline in cable network advertising would be especially painful for TWX shares.
There is also a risk that the TWC spilt falls apart due to the current turmoil in the credit markets and the need for regulatory approval, which continues to drag out. Spending all of its cash on acquisitions as opposed to share buybacks or dividends would also be a disappointment.
My Position
I am long TWX for my clients and in my personal accounts. I started buying my position in early August at $14.87. My most recent trades came this week when I averaged down for some clients between $8 and $8.60.
The Bottom Line
The pending split of TWC and creation of new Time Warner is a positive catalyst. Time Warner will be left with two business generating 70% of profits that should hold together fairly well in 2009. The balance sheet will be very strong, providing plenty of options for enhancing shareholder value. Margins are below par and management is just beginning to implement strategies that have worked well for peers. For the short term or over the long haul, TWX looks like a winner.